Central Bankers Still Don’t Get It (May 2013)

In the wake of the financial collapse of 2007, central banks around the world run by Keynesian zealots religiously applied the formulas they had been taught would boost aggregate demand and rescue the economy from the brink of total catastrophe. Easy money, going under the euphemistic moniker of “quantitative easing” was supposed to stimulate borrowing, spending and growth through the mechanism of historically low interest rates.

Predictably, this approach failed miserably, and more than five years later the United States is still struggling with the high unemployment and low growth of the worst recovery in history. While Canada has done somewhat better, in no small part due to its less aggressive monetary policy, there is still a long way to go towards genuine prosperity. Now, finally, some policy makers are beginning to realize that a different approach is needed. This week, the head of the Canadian Central Bank, Mark Carney, announced that interest rates will slowly be allowed to rise from the current rate of 1% in the future. To call this a modest move would be an understatement, but the fact that, unlike in the United States, the Bank is beginning to move away from the policy of flooding the economy with money in a desperate effort to keep rates artificially low is at least encouraging.

Still, these kind of policy decisions largely miss the point of how the economy really works. While interest rates do need to rise, the fact that the central bank is setting them at all is the true problem that is almost never addressed. Despite the failures of easy money policies to cause a noticeable improvement in economic conditions, central banks maintain the fiction that they can engineer optimal outcomes if only they use just the right combination of policy tools, if only they print enough money, if only they get the interest rate just right.

Interest rates are supposed to function just as the price system does-as a way of coordinating the diverse activities of millions of people and providing that information to borrowers and lenders. When these signals are altered due to artificial tampering by a central bank, it prevents businesses and individuals from being able to make informed investment decisions and results in a misallocation of resources.

The boom and bust cycle commonly thought to be a natural and unavoidable consequence of capitalism is actually the direct result of these malinvestments and the correction process that follows. The pain that results from correction is actually good insofar as it realigns the signalling process with the actual behavior of participants in the economy. The actions taken by central banks to fight this correction only prolong the pain and prevent the economy from coming back into alignment as it should.

As long as central banks continue to meddle with the money supply, investments will not be made efficiently and the economy as a whole will suffer. Unfortunately, the political need to assure voters that the government is taking action in times of recession means that this is a trend unlikely to reverse any time soon. Hopefully the emergence of alternative currencies such as Bitcoin will demonstrate the value of a fixed-quantity, non-inflationary money supply.